Navigating Global Financial System Fragmentation 2025

Scenario 3 – High fragmentation: This scenario forecasts a financial decoupling that ceases all economic exchanges between Eastern and Western blocs. Neutral countries are subject to moderate restrictions on capital and goods flows but maintain their financial linkages and supply chains with both the East and West. The costs of fragmentation are severe for all three blocs, with global output being reduced by 3.6% in the short run. The Western bloc would see a decrease similar to the impact of the Great Recession on its respective economies. Global inflation is estimated to increase by 3.5%. Scenario 4 – Very high fragmentation: The worst- case, and least probable, scenario establishes two distinct economic blocs. All financial and economic activity stops between East and West, and the Neutrals are compelled to choose the side of their largest trading partner. The output losses are highest for Neutrals, who are forced to limited economic exchange to counterparts within a single bloc. In the short run, total global output losses reach 5.5% of global GDP , approximately twice as much as during the COVID-19 pandemic, with global inflation rising by 5.2%. For the Eastern bloc, the impact would be deflationary, as weaker demand translates to easing price pressures. The long-term impact on output remains significant at 4.2%. FIGURE 8 Short-run impact of geoeconomic fragmentation on global inflation 0.6%2.3%3.5%5.2% 0%1%2%3%4%5%6%Marginal impact on global inflation (deviation from the baseline in %) Scenario 1 Low fragmentationScenario 3 High fragmentationScenario 2 Moderate fragmentationScenario 4 Very high fragmentation Source: NERA analysis based on multi-country, multisector model of Baqaee & Farhi (2024).36 Data from 2013 World Input–Output Database and Asian Development Bank’s 2023 Input–Output Tables. Short-run impact is defined as the impact measured one year after the shocks and is based on applying the 1-year to 10-year trade elasticity ratio found in Boehm et al. (2023)37 to the elasticities in Baqaee & Farhi (2024), as in Bolhuis et al. (2023)38 These four scenarios provide estimates for the macroeconomic impact of geoeconomic fragmentation that may change based on different variables, including the resilience of the global financial system. The model serves as a proxy for the different transmission channels, such as regulatory divergence. The country-specific model forecasts for Brazil, China, India and the US show the adjustment to fragmentation over a period of five years. Higher fragmentation provides financial system participants with greater incentives to locate alternative sources of capital or shift to different payment systems to reduce costs in the long term. Navigating Global Financial System Fragmentation 19